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The Banking Panics in the United States in the 1930S for the Financial Crisis of 2007-2008

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The Banking Panics in the United States in the 1930S for the Financial Crisis of 2007-2008 The Lessons from the Banking Panics in the United States in the 1930s for the Financial Crisis of 2007-2008 Michael Bordo Department of Economics Rutgers University and NBER [email protected] and John Landon Lane Department of Economics Rutgers University [email protected] . Paper prepared for a seminar at the Graduate Center, CUNY, Feb 7, 2012. 1 Abstract “The Lessons from the Banking Panics in the United States in the 1930s for the Financial Crisis of 2007-2008” In this paper we revisit the debate over the role of the banking panics in 1930-33 in precipitating the Great Contraction. The issue hinges over whether the panics were illiquidity shocks and hence (in support of Friedman and Schwartz (1963) greatly exacerbated the recession which had begun in 1929, or whether they largely reflected insolvency in response to the recession caused by other forces. Based on a VAR and new data on the sources of bank failures in the 1930s from Richardson (2007), we find that illiquidity shocks played a key role in explaining the bank failures during the Friedman and Schwartz banking panic windows. In the recent crisis the Federal Reserve learned the Friedman and Schwartz lesson from the banking panics of the 1930s of conducting expansionary open market policy to meet demands for liquidity. Unlike the 1930s the deepest problem of the recent crisis was not illiquidity but insolvency and especially the fear of insolvency of counterparties. Michael Bordo John Landon Lane Department of Economics Department of Economics Rutgers University Rutgers University [email protected] [email protected] Keywords: Banking Panics, Financial Crises, Monetary Policy JEL: E52 N12 2 1. Introduction: The Friedman and Schwartz Hypothesis and the Subsequent Debate The Great Depression was by far the greatest economic event of the twentieth century and comparisons to it were rife during the recent Great Recession. Friedman and Schwartz (1963) labeled the downturn in the United States from August 1929 to March 1933 the Great Contraction. Since that event a voluminous literature has debated its causes in the United States and its transmission around the world. This paper focuses strictly on U.S. domestic issues. At the time, the consensus view was that the slump was a consequence of the speculative boom of the 1920s. The boom was regarded as a manifestation of deep seated structural imbalances seen in overinvestment. Indeed according to the Austrian view which prevailed in the interwar period, depressions were part of the normal operation of the business cycle. Policy prescriptions from this view included tight money, tight fiscal policy and wage cuts to restore balance. Keynes (1936) of course rejected these prescriptions and the Classical view that eventually a return to full employment would be achieved by falling wages and prices. He attributed the slump to a collapse of aggregate demand, especially private investment. His policy prescription was to use fiscal policy—both pump priming and massive government expenditures. In the post World War II era, Keynesian views dominated the economics profession and the explanations given for the depression emphasized different components of expenditure. 3 Milton Friedman and Anna Schwartz in A Monetary History of the United States (1963) challenged this view and attributed the Great Contraction from 1929 to 1933 to a collapse of the money supply by one third brought about by a failure of Federal Reserve policy. The story they tell begins with the Fed tightening policy in early 1928 to stem the Wall Street boom. Fed officials believing in the real bills doctrine were concerned that the asset price boom would lead to inflation. The subsequent downturn beginning in August 1929 was soon followed by the stock market crash in October. Friedman and Schwartz, unlike Galbraith (1955), did not view the Crash as the cause of the subsequent depression. They saw it as an exacerbating factor (whereby adverse expectations led the public to attempt to increase their liquidity) in the decline in activity in the first year of the Contraction. The real problem arose with a series of four banking panics beginning in October 1930 and ending with Roosevelt’s national banking holiday in March 1933. According to Friedman and Schwartz, the banking panics worked through the money multiplier to reduce the money stock (via a decrease in the public’s deposit to currency ratio). The panic in turn reflected what Friedman and Schwartz called a ‘ contagion of fear” as the public fearful of being last in line to convert their deposits into currency, staged runs on the banking system, leading to massive bank failures. In today’s terms it would be a “liquidity shock”. The collapse in money supply in turn led to a decline in spending and, in the face of nominal rigidities, especially of sticky money wages, a decline in employment and output. The process was aggravated by banks dumping their earning 4 assets in a fire sale and by debt deflation. Both forces reduced the value of banks collateral and weakened their balance sheets, in turn leading to weakening and insolvency of banks with initially sound assets. According to Friedman and Schwartz, had the Fed acted as a proper lender of last resort as it was established to be in the Federal Reserve Act of 1913 that it would have offset the effects of the banking panics on the money stock and prevented the Great Contraction. Friedman and Schwartz’s “money hypothesis “was attacked by Peter Temin in Did Monetary Forces Cause the Great Depression? (1976). Temin challenged Friedman and Schwartz’s assumption that the money supply collapse was an exogenous event. He argued that money supply fell in response to the downturn. He attributed the collapse in income to a decline in autonomous consumption expenditure and in exports. The fall in income in turn reduced the demand for money and money supply responded. At the heart of his critique is the view that the banking collapses beginning in October of 1930 were not “contagious liquidity shocks” but endogenous “insolvency” responses to a previous decline in economic activity especially in agricultural regions hit by declining commodity prices beginning in the 1920s. This was reflected in a weakening of bank balance sheets. The Temin challenge prompted an enormous literature in the 1970s and 1980s. The upshot of the debate was “that though monetary forces are viewed as the key causes of the Great Depression, non monetary forces emerge as having considerable importance” Bordo ( 1986 page 358). 5 The issue was revisited in the 1980s in a seminal article by Bernanke (1983) who like Friedman and Schwartz, attributed the Great Contraction to monetary forces and especially the collapse of the banking system. However he placed less emphasis on the effects via the quantity theory of money on spending and more on the consequences of the collapse of the banking system in raising the cost of financial intermediation. The issue of the banking panics was revisited in the 1990s in a book by Elmus Wicker The Banking Panics of the Great Depression (1996) who carefully re examined the evidence using disaggregated data from local newspapers and Federal Reserve documents not available to Friedman and Schwartz. He concluded that two of the Friedman and Schwartz banking panics, the fall of 1930 and the spring of 1931 were regional and not national events as Friedman and Schwartz had claimed. The other two panics, fall 1931 and winter 1933, he concurred were national events. Also, in contrast to Temin, he supported the Friedman and Schwartz view that all the panics (both regional and national) were largely liquidity shocks, evidenced in a rise in currency hoarding. He also argued that expansionary Fed open market policy could have offset the panics and prevented the transition in 1930-31 from a serious recession to the Great Contraction. In the past two decades a number of scholars have reopened the issue of the importance of the banking panics for the U.S. Great Depression and especially whether they reflected illiquidity or insolvency. Following Temin, Wicker and White (1984), this literature has focused on disaggregated individual bank data categorized by types of banks and by data 6 sources, in contrast to the macro approach taken by Friedman and Schwartz and Bernanke. Section 2 discusses some of this literature. Section 3 briefly examines why the U. S. had so many bank failures and was so prone to banking panics in its history. Section 4 provides some econometric evidence on the issue of illiquidity versus insolvency and also discusses some of the methodological issues in using macro time series versus using disaggregated data. Section 5 compares the financial crises of the 1930s in the U.S. to the recent financial crisis 2007-2008. Section 6 concludes with some lessons for policy. 2. The Recent Debate over U.S. Banking Panics in the 1930s: Illiquidity versus Insolvency. In this section we survey recent literature on whether the clusters of bank failures that occurred between 1930 and 1933 were really panics in the sense of illiquidity shocks.1 This has important implications for the causes of the Great Depression. If the clusters of bank failures were really panics then it would support the original Friedman and Schwartz explanation. If the clusters of bank failures primarily reflected insolvency then other factors such as a decline in autonomous expenditures or negative productivity shocks (Prescott1999) must explain the Great Contraction. Friedman and Schwartz viewed the banking panics as largely the consequence of illiquidity, especially in 1930-31. Their key evidence was a decline in the deposit currency ratio which lowered the money multiplier, money supply and nominal spending. They describe the panic in the fall of 1930 as leading to “a contagion of fear’ especially 1 Panics can arise because of exogenous illiquidity shocks in the context of the Diamond and Dybvig ( 1983) random withdrawals model or in the context of asymmetric information induced runs and panics ( Calomiris and Gorton, 1991) 7 after the failure of the Bank of United States in New York City in December.
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